Go-Go Emerging-Markets Funds' Risks Are Again Clear

We've long been suspicious of exceptionally aggressive emerging-markets funds--such as those that focus exclusively on a single country or a small region and those that follow daring stock-selection strategies--while we've always thought that relatively conservative emerging-markets offerings make a lot of sense. There are four reasons for our views. First, emerging-markets funds are quite explosive by definition. Second, the extra upside potential that extremely bold ones take on is often more than offset by the extra geographic or other risks that they assume. (For example, single-country emerging-markets funds have nowhere to hide when trouble hits their chosen market, and they're generally quite focused with regard to sector.)  Third, the less-pronounced losses that those with broader and more-reserved strategies suffer during downturns frequently make up for the gains that they forgo during rallies. And fourth, the performance extremes of exceptionally aggressive funds make it hard for investors to stay the course with them, while the relatively smooth performance of more-conservative offerings makes them fairly easy to use.

Frankly, our conservative biases were out of step with market trends from early 2003 through late 2007, and we looked like curmudgeons. Emerging-markets funds enjoyed terrific conditions during that period. Strong global growth led to robust demand for emerging-markets goods and services. Domestic policies and conditions were quite favorable in most of the developing world and truly spectacular in China, India, and certain other places. And investors became more and more enamored with emerging-markets securities. Thus, between April 1, 2003, and Oct. 31, 2007, diversified emerging-markets funds delivered a fantastic 43% annualized return, while China, India, and certain other types of exceptionally aggressive emerging-markets funds produced even more stunning annualized returns.

But the climate for emerging-markets funds has taken a marked turn for the worse since late 2007. Housing, credit, and other problems in the United States have undermined economic growth here and abroad, and big increases in the prices of energy and other commodities have exacerbated the situation. Fears of inflation have beset several developing nations, with China and India being especially hard-hit. These negative macroeconomic developments have combined with worries about valuations to cause many investors to sour on emerging-markets stocks. As a result, diversified emerging-markets funds dropped 19% between Nov. 1, 2007, and July 1, 2008. It was worse for some of the more targeted funds: China offerings plummeted 37% and India funds plunged 42%.

These losses, of course, underscore the appeal of conservative emerging-markets funds. But investors who are interested in such funds should be sure that they understand two facts. First, several of the offerings that have held up relatively well over the past eight months aren't reserved at all. Latin America, Russia, and Middle East funds have suffered only small losses or posted gains since Nov. 1, because they focus primarily or exclusively on commodity-oriented markets, but they're actually quite risky and subject to major sell-offs because of their sector and geographic concentrations. Second, some of the best conservative emerging-markets funds are closed to new investors, including Dreyfus Premier Emerging Markets DRFMX and Matthews Asian Growth & Income MACSX, which have lost much less than their category norms during the current and most past downturns and which have posted strong long-term returns.PAGEBREAK

Fortunately, however, there are a couple of genuinely reserved emerging markets that remain open to new investors and that are quite attractive overall, namely Lazard Emerging Markets LZOEX and American Funds New World NEWFX. Lazard Emerging Markets has lost less than the vast majority of its rivals over the past eight months, has held up relatively well in most past sell-offs, and suffered significantly less overall volatility than its peers, thanks to its managers' attention to valuations and commitment to diversification. And although it has sometimes lagged in the later stages of prolonged rallies, its long-term returns are pretty good, as the managers have captured solid gains during the bulk of the rallies and the fund has a penchant to avoid the most serious damage in rough conditions.

Finally, American Funds New World has lost only about half the group norm during the current decline, faring better than all other diversified emerging-markets offerings. The fund held up particularly well in most prior storms, and it has been the least volatile member of its group overall. The main reason for the fund's resilience is that it is wider-ranging than traditional emerging-markets offerings. Its managers divide the portfolio between straightforward emerging-markets names and developed-markets firms that have significant business in the developing world, such as current top-five holding Novo Nordisk NVO, a Danish drugmaker with significant and growing sales in emerging markets. And while its developed-markets exposure has slowed returns during rallies and over the long term, the fund's since-inception gains are strong in absolute terms, and they're decent in relative terms--even though emerging markets have enjoyed generally favorable conditions during its life. An exceptionally low expense ratio rounds out it appeal.

William Samuel Rocco is a fund analyst with Morningstar.

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